Spirit Airlines: High Risk, High Reward

Summary

• Spirit Airlines trading below book value after -50% plunge.
• Stock is a risky bet with multiple unknowns, and a large potential payoff upon eventual coronavirus recovery.
• Cautiously bullish at $20/share, even in reasonable $1 billion loss doomsday scenario.

After falling 50% since news broke of COVID-19 outbreaks in South Korea and Italy two weeks ago, Spirit Airlines (NYSE:SAVE) is now trading at 5 year lows and 75% tangible book value, as the market absorbs the implications of a coronavirus pandemic. If the company were to liquidate all assets immediately at market value, shareholders at today's prices would see sizable appreciation in capital...the problem is, no one wants to buy planes in this market. With news that German airliner Lufthansa is cutting capacity by up to 50% in the next few months, US airlines may be following suit, as the United States appears to be lagging Europe by a couple of weeks in terms of disease progression/reported cases (the argument can be made that the lag is actually non-existent since the US falls far short of European counterparts in number of people tested). Given the coronavirus black swan and Spirit's precipitous drop in market value in only two weeks, is it a buy for investors today? I am bullish, but cautiously so...as it stands, Spirit is a high risk/high reward play with multiple unknown variables that will crystallize in the days to come.

On one hand, Spirit looks like one of the riskiest bets in the airline sector, with a below investment grade credit rating of BB-/Ba3 that is matched only by American Airlines (AAL). However, in this unique environment, the criteria by which credit rating agencies assign their scores may not be fully relevant...for instance, fleet size and diversity of routes would not insulate an airline from a pandemic-related demand shock that is not localized. Looking at balance sheet data, Spirit appears well positioned to weather the coming storm, far more so than its peers: it currently holds a cash balance equal to 28% of its yearly revenue, versus 8% for American Airlines, 6% for Delta (DAL), 18% for Southwest (LUV), 11% for United (UAL), and 16% for JetBlue (JBLU). In the event demand dries up and earnings go negative, Spirit has a formidable war chest to draw down on to pay fixed costs such as employee salaries and aircraft rent. Other tailwinds include record low oil prices, which look like they'll be sustained in the near future as negotiations between Russia and OPEC+ collapsed last Friday. Although low fuel prices won't help Spirit if the situation becomes severe enough that a significant percentage of the fleet needs to be grounded, it could soften the blow to earnings until we reach that point of peak fear by raising the profitability of existing flights. Unlike competitor Southwest, Spirit doesn't hedge fuel costs at all, so it will reap full benefits from the drop in oil.

That said, the investment thesis in Spirit does contain multiple headwinds, some highly significant. Firstly, Spirit has on order nearly $1 billion in planes and spare engines to be delivered in 2020...its aggressive capacity expansion relative to peers has proven to be a liability in the current market environment, as those jets will almost certainly not be deployable this year. Spirit may survive, or not, based on how successfully it can re-negotiate its purchase obligations with Airbus. Secondly, Spirit's business is highly concentrated in Florida, which has a large elderly population that is especially vulnerable to the coronavirus. Finally, as a ULCC, Spirit's planes have the highest seat density in its peer group: although this configuration may drive down costs, it may also turn away travelers who would prefer to be seated around as few people as possible to minimize infection risk. This last point may be counterbalanced by the fact that Spirit's fleet is younger and presumably has more advanced air filtration systems, but it's doubtful that most travelers would take this into account (or even be aware that planes cycle their air through HEPA filters).

Airline investors are now in an unprecedented situation that may have consequences for the industry far beyond 9/11, the 2003 SARS outbreak, the financial crisis, and the 2009 swine flu outbreak. If you believe the coronavirus will just be a blip in the market, the virus will be contained, and normal economic activity will resume shortly, then airlines today are a screaming buy. If you believe that COVID-19 is here to stay and will cause a permanent paradigm shift in how people congregate and travel, then they may not be a buy at any price. I'm somewhere in the middle...based on reports by leading epidemiologists, I believe COVID-19 is much more serious than the general population is giving it credit for, but I do think its economic impact, while substantial, will be restricted to the near term. I predict airlines will take a huge hit over the coming year, more than what many analysts are forecasting, and some may go bankrupt, but the strong ones will survive and carry on.

In my own worst case scenario forecasts, I see Spirit losing up to $1 billion this year. However, because of its strong cash position, I believe the company will survive the incoming storm, and at the $20/share price level, I am a cautious bull (it has already lost over a billion dollars in market cap since 2/1). Let's pretend we're Warren Buffett going elephant hunting: if we were to buy Spirit outright, we can acquire the whole operation for a measly $450 million after stripping out cash on hand, which buys us $300 million in recurring annual profits and $1.1 billion in net assets. Of course, we would also take on Spirit's debt obligations as well, but with an interest coverage ratio of 5.9, the company should be more than able to handle its own loan expenses. This is a deep value play if I've ever seen one. SAVE has been beaten up far more than its peers over the past two weeks, undeservedly so. Spirit remains an innovative, agile company that is best of breed in the ULCC space. As a high risk, high reward bet, patient SAVE investors are positioned to reap massive gains off the back of an eventual coronavirus recovery...as long as they can tolerate the possibility of complete capital destruction.

Analyst’s Disclosure: I am/we are long SAVE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.